2020 Volume 8 Pages 29-56
In the countercyclical capital buffer regime of the Basel III framework, the credit-to-GDP ratio is proposed as a guide to adjusting capital requirements. To date, the effectiveness of the credit-to-GDP guide has not been fully comprehended. We assess the effectiveness of the credit-to-GDP ratio as a guide to implementing counter-cyclical capital requirements by using a simple macroeconomic model. We show the results that the credit-to-GDP ratio is not an effective guide during a recession. A slowdown in aggregate output—the denominator of the credit-to-GDP ratio— requires the authorities to return the capital requirements near to its level in normal times even though the economy is still in a recession. This limits improvement in the supply of funds to the production sector and subsequently leads to an adverse reaction in real economic activity. The results imply possible drawbacks of the countercyclical capital buffer regime.
